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Real estate supply: the forgotten part of the equation

Cities vary markedly in terms of the ease of developing commercial real estate. Geographical, regulatory and fiscal barriers to entry are more significant in some cities than others. Key local players’ attitudes towards development also vary and play an important role in how much office space is built in response to rising demand.

Understanding these dynamics enables investors to make better judgments about the level of supply risk in individual markets. It also allows them to make better predictions about the
rental
outlook, and time their investments accordingly. In particular, it is crucial investors monitor the potential for regulatory change in their target markets as this can decisively alter a city’s capacity for supplying real estate.

Historical balance of supply and demand

There are significant differences in supply responsiveness between cities. To distinguish between markets, it is helpful to look at the historical balance of supply and demand in the office sector. The supply response tends to be relatively strong relative to demand in cities such as Warsaw, Lisbon, Rotterdam, Dublin and Paris’s La Défense district. Conversely, a weak supply response is a feature of London’s West End and Mid-town districts, Paris’s central business district, and Stockholm.

Unsurprisingly, supply responsiveness is negatively correlated with rental growth. Cities with high supply responsiveness have underperformed in terms of average market rental growth. Meanwhile, those with low supply responsiveness have outperformed.

The relationship also holds for prime rental growth. The most attractive office spaces are typically more resilient to oversupply in the overall market compared to secondary office space. For some occupiers, demand elasticity is very low as they need to be in the most attractive locations and buildings in order to promote their brands and attract talent. However,
prime
real estate is not immune to oversupply. Most occupiers will negotiate their rental agreements based on conditions in the overall market.

Barriers to office development

Some European cities are clearly more supply-constrained than others. Barriers to entry for developers in such cities include:

Existence
of established, dense city cores: land scarcity limits the potential for new development.

Transportation infrastructure: poor connectivity within a city limits competition from surrounding areas.

Local agglomeration effects:
clustering
of businesses from a particular industry in one
micro location
has extensive agglomeration benefits for tenants. Other districts are unable to attract such occupiers by merely providing cheaper office space.

Attitudes of residents and planners: the extent of NIMBYism (Not in My Backyard) attitudes.

Behaviour
of developers: Academic research suggests developers act more rationally in some markets, basing decisions on anticipated changes in demand, and less rationally in others, where they respond to current demand.

European comparisons

UK – home to the most expensive real estate in Europe

Office space in UK cities is among the most expensive in the world. Fiscal disincentives to development are considerably greater than in any major European country, while UK planning regulations also have an impact. Measures limiting
vertical
and horizontal expansion of cities exist across the country. In London, the ‘green belt’ additionally constrains the horizontal expansion of the city, particularly for residential development.

The UK’s planning system differs from its continental European peers. Local plans are not legally binding and allow for more negotiation before a decision is given. Planning is flexible and discretionary, in contrast to the rest of Europe where decisions are based strictly on compliance (or lack of compliance) with local planning rules. The UK’s flexible system has its benefits but is also a source of uncertainty for developers, increasing their risks and costs, and therefore acts as a barrier to entry.

Germany’s federal system encourages
development

The German devolved tax system incentivises local authorities to approve the development of
commercial
real estate. The second difference between Germany and the UK is in the nature of land use regulations. While the German planning system is no more efficient, it is more transparent.

Barriers to entry do exist in German cities, with local planners generally averse to large-scale office buildings. Development is strongly influenced by local planners’ ideas about how a city should look. Height restrictions exist in all German cities with the exception of Frankfurt, which prioritises sustaining its international competitiveness as a financial centre over protecting its historical centre. Height restrictions are particularly evident in Munich, where constructing buildings higher than the cathedral is prohibited.

While there are no explicit green belt policies in German cities, there is a planning premise of internal before external development; meaning development on brownfield land is preferred to building on farmland. This is aimed at limiting cities’ horizontal expansion.

Nevertheless, Germany appears to be a market with much lower barriers to entry compared to the UK.

The French middle road

France appears to sit between the UK and Germany in terms of supply restrictiveness. As in the rest of continental Europe, its planning system is legally binding. This makes it easier and less costly for developers to comply. But France is a more centralised country compared to Germany, with local authorities enjoying less autonomy.

As in the UK, the French tax system is relatively centralised. Local authorities receive a much smaller slice of the cake than their German peers.

France has an equivalent to the UK’s business rates – Cotisation Foncière des Entreprises (CFE). Similar to the UK, this tax is based on the rateable value of the property occupied by the business. The tax is capped at three per cent of value added by businesses and so is relatively small. In addition, it is split between communes, departments and local public institutions. It is therefore by no means a meaningful incentive for local authorities to promote
development
of
commercial
real estate.

Conclusions

Supply risks are underestimated by investors, despite variations between cities and a clear link between supply responsiveness and rental growth.

Investors should strive to understand how supply is likely to respond to changes in demand in individual locations. This will provide them with a competitive edge, allowing them to project rental prospects more accurately and time their investments accordingly. Cities with high regulatory and fiscal barriers to entry as well as dense, established urban cores with a concentration of high value-add activities are likely to generate robust rental growth in the long term.

Investors should also monitor the potential for regulatory change. Market dynamics can change strikingly as a result of government intervention. Such transformation took place in the City of London in the 1980s, New York in
early
2000s and Amsterdam after the global financial crisis.

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Important information

Except where stated as otherwise, the source of all information is Aviva Investors Global Services Limited (Aviva Investors) as at May 25 2018. Unless stated otherwise any view sand opinions are those of Aviva Investors. They should not be viewed as indicating any guarantee of return from an investment managed by Aviva Investors nor as advice of any nature. Information contained herein has been obtained from sources believed to be reliable, but has not been independently verified by Aviva Investors and is not guaranteed to be accurate. Past performance is not a guide to the future. The value of an investment and any income from it may go down as well as up and the investor may not get back the original amount invested. Nothing in this document, including any references to specific securities, assets classes and financial markets is intended to or should be construed as advice or recommendations of any nature. This document is not a recommendation to sell or purchase any investment.

In the UK & Europe this document has been prepared and issued by Aviva Investors Global Services Limited, registered in England No.1151805. Registered Office: St. Helen’s, 1 Undershaft, London, EC3P 3DQ. Authorised and regulated in the UK by the Financial Conduct Authority. Contact us at Aviva Investors Global Services Limited, St. Helen’s, 1 Undershaft, London, EC3P 3DQ. Telephone calls to Aviva Investors may be recorded for training or monitoring purposes. In Singapore, this document is being circulated by way of an arrangement with Aviva Investors Asia Pte. Limited for distribution to institutional investors only. Please note that Aviva Investors Asia Pte. Limited does not provide any independent research or analysis in the substance or preparation of this document. Recipients of this document are to contact Aviva Investors Asia Pte. Limited in respect of any matters arising from, or in connection with, this document. Aviva Investors Asia Pte. Limited, a company incorporated under the laws of Singapore with registration number200813519W, holds a valid Capital Markets Services Licence to carry out fund management activities issued under the Securities and Futures Act (Singapore Statute Cap. 289) and Asian Exempt Financial Adviser for the purposes of the Financial Advisers Act (Singapore Statute Cap.110). Registered Office: 1Raffles Quay, #27-13 South Tower, Singapore 048583.In Australia, this document is being circulated by way of an arrangement with Aviva Investors Pacific Pty Ltd for distribution to wholesale investors only. Please note that Aviva Investors Pacific Pty Ltd does not provide any independent research or analysis in the substance or preparation of this document. Recipients of this document are to contact Aviva Investors Pacific Pty Ltd in respect of any matters arising from, or in connection with, this document. Aviva Investors Pacific Pty Ltd, a company incorporated under the laws of Australia with Australian Business No. 87 153 200 278 and Australian Company No. 153 200 278, holds an Australian Financial Services License (AFSL 411458) issued by the Australian Securities and Investments Commission. Business Address: Level 30, Collins Place, 35 Collins Street, Melbourne, Vic 3000

The name “Aviva Investors” as used in this presentation refers to the global organization of affiliated asset management businesses operating under the Aviva Investors name. Each Aviva investors’ affiliate is a subsidiary of Aviva plc, a publicly- traded multi-national financial services company headquartered in the United Kingdom. Aviva Investors Canada, Inc. (“AIC”) is located in Toronto and is registered with the Ontario Securities Commission (“OSC”) as a Portfolio Manager, an Exempt Market Dealer, and a Commodity Trading Manager. Aviva Investors Americas LLC is a federally registered investment advisor with the U.S. Securities and Exchange Commission. Aviva Investors Americas is also a commodity trading advisor (“CTA”) and commodity pool operator (“CPO”) registered with the Commodity Futures Trading Commission (“CFTC”), and is a member of the National Futures Association (“NFA”). AIA’s Form ADV Part 2A, which provides background information about the firm and its business practices, is available upon written request to: Compliance Department, 225 West Wacker Drive, Suite 2250, Chicago, IL 60606

RA18/0569/01052019

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